October 2013

This quarter's letter will run long and have several charts, so please grab a beverage and set aside about 25 minutes.

Demographics, Debt, the Economy and Markets

Over the past several years, I have discussed the monumental demographic changes that not only America is dealing with, but also that Europe, China and Japan are dealing with. The cumulative impact of national and personal debts, de-leveraging from the bubbles of the 2000s and the four largest economies in the world having aging populations has created global demand destruction that is not likely to end soon.  

Among the four largest economies, America is best positioned to thrive in the long-term as the United States has both a younger generation that is large in size entering the labor force and a massive new advantage in energy. In the short run however, America has significant debt, health care and inequality challenges to deal with. These challenges will prevent America from having a true growth economy for at least several more years and quite possibly longer if government continues to wage ideological battles rather than implement pragmatic policies to offset the mistakes of the past.  

As I discussed in our April letter "The Great Normalization" we should be prepared for a return to volatility as the secular bear market enters its final innings. A secular market is one that is longer-term in nature and represents the broad trend for usually a decade or longer period. A cyclical market by contrast is the shorter-term ebbs and flows of the market for a few years at a time.

From 1982 to 2000, the United States was in a secular "bull" market, that is, the broad trend was up. In 2000 a secular bear market began.

Market Secular Cycles

Source: Haver, Factset, Robert Shiller, FMRCo. Monthly Data, since 1871. As seen at http://www.ritholtz.com/blog/2013/02/is-the-secular-bear-market-ending/

Right now, we are likely somewhere in the second half of the secular bear market which began in 2000. This period has been marked by periods of extreme volatility, market corrections, cyclical stock market rallies and overall an extended period of very low investment gains.

What we can see from the chart is that based upon the length of secular bear markets of the past, that there is probably several more years to go in this secular bear market. If that is the case, then we can expect at least one more significant stock market correction before entering the next secular bull market.

What most people hope of course, is that this current 13-year period of the markets having reached the same set of highs three times now, does not give us one more severe downturn. Dealing with another major downturn in markets is the last thing that anybody wants to think about, however, it is the first thing we should think about. In particular, we need to be aware that not only are global stock markets at risk, but so are global bond markets due to historically low interest rates. A dual stock market and bond market collapse could be particularly devestating.

There is the possibility that we have already entered a secular bull market as of 2009. This is unlikely, but it could be. We won't know for several more years. If the secular bear market in fact did end with a maximum selling collapse in 2008-09 (generally the final correction is not as bad as earlier), that would be extremely unusual and maybe unprecedented. A secular bear market of only about 9 years would be the shortest secular bear market since the Dow Jones Industrial Average was first used in 1896.

If the stock market continues up from here for an extended period, which is possible given the extreme nature of Federal Reserve money printing, then the next crash will be more severe. In the following chart we can see the impact of the Federal Reserve adding assets to its balance sheet and the S&P 500 stock market index. 

Fed Assets and the stock market

What the above chart shows quite clearly is that since the 2008 financial collapse began, the Federal Reserve response has been to dramatically expand its balance sheet. This expansion, called quantitative easing, has occurred primarily as the Federal Reserve has purchased U.S. Treasuries and mortgage backed securities. What we see is that there is a strong correlation between Fed "money printing" and the price of stocks going up. We also see that their is diminishing returns on the new money printing, i.e. the new dollars do not stimulate as much as the first printed dollars did.

Very importantly and unfortunately, during this same period, employment and gross domestic product have not done as well as the stock market despite the Fed's best efforts.

Things to Consider

The Taper vs Inflation

Earlier this year the stock market saw a mini-correction when talk of the Federal Reserve buying fewer assets - reducing and then ending quantitative easing - became public. As we can see from the chart above, each time the Federal Reserve has ended a quantitative easing program, the stock market has suffered a small correction. That is not necessarily bad, but it is quite telling. It basically confirms to us that stock market prices are largely rising due to the Federal Reserve money.

One question that I have been asked by several folks is "why don't we just keep doing quantitative easing if it pushes the stock market up?" The answer is that quantitative easing or "printing money" causes inflation once it reaches a certain level.

According to the analysis I believe, in the past year we have about reached the point where additional money will someday cause inflation. The early money that the Federal Reserve put into the system went primarily to recapitalize the devastated banking sector. The banks are, for the most part, now strongly capitalized. Adding more money to the system from here would likely become problematic, i.e. significant inflation. 

Therefore, the Fed is at some point going to slow and then stop the excess creation of money. Most informed observers believe that will happen next year, but possibly be pushed into 2016's election season.

What many fear, including me, is that the tapering continues to get put off and we reach a peak that can only be crashed off of and then severe inflation will set in afterward due to a weak dollar. There is a misguided notion that the "wealth effect," - the idea that higher stock and real estate prices lead people to spend more - creates more economic activity. That is only true to a point. There is an extremely large body of evidence to suggest that we are at that point.

If the Fed can smoothly normalize monetary policy and manage expectations, then hopefully the stock market only reacts with a normal correction, i.e. 10% to 20%, rather than a collapse of 40% or more. A 20% correction under strong dollar circumstances is a buying opportunity. A 40% correction with a weak dollar would damage the economy and markets for a long time, quite likely over a decade.

It is vitally important that we maintain a strong enough dollar that it remains the planet's reserve currency. I have talked about this in other letters and articles. Being the reserve currency prevents inflation in America from getting out of hand and preserves our standard of living. We can preserve the dollar's value with just a handful of smart decisions and a little patience. 

We will see what happens this autumn under Ben Bernanke's last days as Fed Chairman and next spring when the new Fed Chairperson arrives - Janet Yellen has been nominated but not confirmed. I am hoping that we see Ben Bernanke begin Fed tapering before year-end, even if small. If we can eliminate quantitative easing in 2014, see only a normal 20% correction to the stock market and regain strength in the dollar - which is good for your purchasing power, i.e. lower prices on stuff, then more of America benefits than currently are, and ultimately asset prices reflect better value as well.

Unfortunately, many politicians and central bankers use inflation as a hidden tax to pay for their failed and/or corrupt policies. We will see what route the government and central banks take, however, it is clear that a stronger dollar is best for the most people. In short, less money printing and a gradual move towards a more balanced federal budget is in almost all of our best interest because those two things will control inflation and lead to higher standards of living for most.

My belief is that due to our massive strength in natural resources (which I discuss repeatedly at The American Resource Boom Letter), medicine, technology, finance and high-end manufactured goods that a stronger dollar would have little impact on growth. In fact, since the value of our money would be stronger and the things we have to sell are less price sensitive to end buyers than low end goods, a stronger dollar is very beneficial  for America going forward as it controls inflation and brings more money into America. Under that scenario, growth and stronger money would help us offset our demographic expenses.

Corporate Earnings and Revenue

Although the stock market has indeed risen on stronger corporate earnings, those earnings are a bit of a sham. Two things have largely powered earnings growth:

  1. Reduction in labor costs, i.e. wages and employment.
  2. Stock buybacks.

Neither of those two things can go on much longer. Ultimately, fewer people working and lower wages stunts growth even more in America, which is already growing extremely slow. As I discussed in "Prepare for zero real growth in the U.S. in 2013" at the start of the year, America was very likely to have a stand still year economically. According to most estimates, that has in fact happened as GDP growth and inflation are about the same. 

If growth slows even more, and I expect it will unless politicians and the Fed cooperate on a few things, then we will get a recession soon. At that point, due to lower revenue, stock buybacks will also be reduced. Without a reduction in stocks outstanding, and flattish earnings, then it is almost inevitable we see a stock market correction in 2014. Again, the question is timing and severity.  

Already we see that earnings growth has slowed:


Corporate Earnings Growth

Health Care Expenses

Here I know that many people expect a tirade about the Affordable Care Act, i.e. ObamaCare. As somebody who has been health insurance licensed for twenty years, I think the ACA is the least of our problems. 

Here's what we know about it so far about it:

  1. More people are being covered than five years ago.
  2. Primary care is replacing expensive emergency room care for previously uninsured.
  3. Private health insurance companies are providing the insurance.
  4. Health care costs are rising at the lowest rate in 50 years.

Each of these points is important. Having more people covered expands the risk pool and should lead to greater efficiency. Simply getting the uninsured out of the ER and into primary care is a huge cost saver. Private insurance companies continue to provide services which is good for efficiency as well. Overall, health care costs are rising slower than in a long time and that should reflect itself in flattening premium costs in time.

I won't argue that the ACA is a great law. It isn't. But it is not horrible either given where we were. Like many young companies, we need to wait and see if the necessary tweaks are made and execution is strong (the exchange rollout appears to be the first major snag) over time.

Read this letter from the recently retired Chairman, President CEO of Blue Shield of California and a note from the American College of Emergency Physicians. 

This chart from a recent Wall Street Journal article shows that medical inflation is already at its lowest point in 50 years:

Medical Inflation

The healthcare problem you really need to be worried about is Medicare. Currently there are about 51 million people on Medicare - about 42 million due to turning age 65 and 9 million due to disability. There are 10,000 baby boomers turning 65 and going onto Medicare EVERY DAY. Currently, the U.S. Government spending on Medicare is approaching $600 billion per year and growing fast.

Right now, the Medicare premium paid by most seniors is $105 per month, the disabled generally don't pay. Let's do some math. The average senior is paying $1260 per year in Medicare premium. There are 42 million seniors. That's about $52.5 billion. That's quite a bit lower than the $600 billion spent. The balance of costs come from employment taxes. Even with some savings in place, Medicare is about to go deeply in the red and become a significant tax suck. That is your health care dilemma.

Of note, the ACA cuts Medicare reimbursements, so that will help curb Medicare expenses about 10% to 20%. There is also an emphasis on preventive health care. This comes with a small upfront cost, however, it will also cut Medicare expenses over time.

Exact SciencesTechnology is also important for bringing health costs down. Better screening for disease will also reduce costly treatments. One of the healthcare companies we are invested in is Exact Sciences which is bringing to market a non-invasive screening test for colorectal cancer. Based on a cost vs benefit analysis of that test, Medicare stands to save billions on cancer treatment costs. There are several other companies we are exploring investing in with similar aims.

Even with the fixes already in place, we must find other approaches to balancing the Medicare budget, including raising the Medicare Part B deductible substantially. If we don't find a way to curb Medicare expenses more - because there is NO WAY to tax our way to even - then we are doomed to an economic collapse. Medicare is on the verge of being that dangerous. Medicare is the big elephant in the room.

Tactical Asset Management

Refocusing this letter again on investing, I want to discuss the very definitive investment move that I have made this year.

First some history. Before the crashes of 2000-2002 and 2008-2009 I discussed with other financial people, including colleagues, that it looked likely to me that we were in store for large stock market corrections. Both times I was told I was wrong and that "it was different" this time. Luckily I didn't listen to those people and sidestepped much of those crashes. 

In 2008, the brokerage I was affiliated with made it difficult for me to act on my convictions. They did not want me holding significant cash balances or shorting the stock market. I held cash and shorted the banks via an ETF (exchange traded fund) anyway.

When the 2008-2009 ordeal was over, and I had done relatively well, I knew it was time I started my own business. Part of what I wanted to do was bring institutional level investment management to my clients. That required finding great people in the industry to partner with who were willing to work with any client who wanted a better financial experience.

My search for great investors led me to the stock pickers, trend traders and quantitative managers who I watched do very well in the 1990s and 2000s. One of them even bought the Boston Red Sox (no small price tag), another lives in Omaha. 

The managers who did the best, have always been able to avoid large losses. Algebraically, avoiding big losses has led to the best performance over an entire cycle, even if all the gains are not captured in the up markets. 

How often have we heard that "the best offense is a great defense?" That philosophy, which is true in sports, is also true with investing. Because losing requires a larger gain just to get back to even, the best investment approaches focus on not losing significantly in the first place.

In building my firm, what I needed for most client money was an asset allocation strategy that protected accumulated wealth and allowed for growth over time.

The best asset allocation approach I have found is called "tactical asset management" which is largely based upon reacting to the mathematics of the markets.  

Tactical Asset Management

As of this year, I have adopted a variation of the tactical approach for my client's accumulated assets which in my opinion is both safer than mutual fund investing and offers tremendous long-term upside potential.

To best implement this approach, after nearly three years of looking for a money manager I could trust, I found one who satisfied the demanding and fairly obnoxious list of requirements which I laid out. His name is Matt Tuttle and he actually wrote the book on investing like an institution.

Normally, an investment manager of the caliber of Matt would require a million dollar minimum account size at least. Through Bluemound, he is available to virtually anybody who is looking for a better investment experience.

Most firms still use backwards looking data for managing money that does not account for the developing risks in the world. Moreover, their approaches, regardless of what they call them, are generally based upon failed strategies and ideas that have fully participated in crashes, i.e. lost a lot of money.

Our tactical methods are focused on active risk management which is constantly evolving. We invest where the numbers lead us, either seeking gains or safety, while we ignore the emotions and noise that are constantly in the news and the markets. 

Using our tactical approach to investing allows us to reach three core investment goals:

  1. Guard against major long-term losses (i.e. 2008)
  2. Have cash available for major market opportunities (i.e. 2009)
  3. Take advantage of confirmed trends (i.e. 2010 to 2013)

An easy way to think about our version of tactical is that we put money where it is being treated best. We are not married to some pre-defined asset allocation model. We can move away from danger, we can move towards opportunities, wherever it is. Imagine your investment pie chart and know that we are deciding which slices to increase or decrease in size, or remove completely, based upon objective risk-measured criteria.

Mechanically, we are generally using low cost ETFs (exchange traded funds) to implement our strategies.

I still also manage focused stock portfolios - called "Punch Card" strategies after a Warren Buffett thought - for the more assertive portion of client's money that can accept more volatility. In those strategies, I continue to use options to mitigate risk and leverage opportunity. Over very long periods, the stock portfolios can give us home run potential when done well. 

The "Punch Card" stock portfolios only fall into our long-term investment bucket which is for money with a 15 year time horizon. Tactical asset management strategies (we have several) holds virtually all of our intermediate term investment bucket money with time horizon of 3 to 15 years. Bank assets are for the short-term and emergency money bucket.  

Finish Your Drink 

So, that is the state of the financial world in my mind in 3149 words or less.

In short, if you skipped everything above other than the charts, we are focused on managing risks, both knowable and unknowable, as well as, participating in upside that does not expose us to large losses. 

With that, I am going to hit save. You're welcome.